SU9: Investment Decisions

Question 1

Stages of Capital Budgeting

Answer 1

1. Identification and Definition
2. Search
3. Information-Acquisition
4. Selection
5. Financing
6. Implementation and Monitoring

Question 2

Steps in ranking investments

Answer 2

1. Determine asset cost or net investment
2. Calculate estimated cash flows
3. Relate the cash flow benefits to their cost
4. Rank the investments

Question 3

Hurdle rate

Answer 3

Minimum rate of return on a project or investment that an investor is willing to accept

Question 4

Salvage value note…

Answer 4

Salvage value is never subtracted when calculating the depreciable base for tax purposes. General rule - the new equipment will result in higher depreciation than the existing equipment. This tax savings is the dax depreciation shield.

Question 5

Ordinary annuity

Answer 5

end of each period. also known as annuity in arrears.

Question 6

annuity due

Answer 6

beginning of each period. also known as annuity in advance.

Question 7

certainty equivalent

Answer 7

certainty equivalent - at what point a firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum

Question 8

Monte Carlo Simulation

Answer 8

generate the probability distribution of all possible outcomes from a capital investment.

Question 9

Two most widely used rates for discounts rates

Answer 9

1. weighted average cost of capital

2. shareholders opportunity cost of capital

Question 10

IRR equation

Answer 10

rate at which the initial investment is equal to the NPV of annual cash flows

Question 11

Payback period

Answer 11

initial net investment / annual expected cash flow

Question 12

undiscounted payback periods are always <> than discounted payback periods

Answer 12

faster

Question 13

bailout payback method

Answer 13

incorporates the salvage value of the asset into the calculation/measures the risk if a project is terminated.

Question 14

payback reciporical

Answer 14

1 divided by payback

Question 15

profitability index

Answer 15

present value of future net cash inflows divided by the present value of the net initial investment

Question 16

when to use profitability index

Answer 16

if index greater than 1, then accept

if less than 1, then reject

Question 17

Internal capital market

Answer 17

a way of referring to the provision of funds by one division of a firm to another division. A division operating in a mature industry that generates a lot of cash can provide funding to another division that is in the cash-hungry development stage.

Question 18

Linear programming

Answer 18

a technique (now usually computerized) for optimizing resource allocations so as to select the most profitable or least costly way to use available resources.

Question 19

Identify three weaknesses in using payback period

Answer 19

1. ignores cash flows after calculated payback period
2. payback period does not discount future cash flows, tehrefore ignoring time value of money
3. choice of cutoff period is arbitrary.

Question 20

Identify three techniques or methods that can be used to quantify and assess risk

Answer 20

Sensitivity analysis, breakeven analysis, risk adjusted discount rates, monte carlo simulation, decision trees, certainty equivalent

Question 21

Technique for evaluating projects when capital is rationed and there are no mutually exclusive projects from which to choose

Answer 21

Profitability index

Question 22

The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when

Answer 22

Multiple projects have unequal lives and the size of the investment for each project is different.

Question 23

Under what circumstances does the IRR become misleading?

Answer 23

When the direction of cash flows changes (positive in year one, negative in year two OR negative in year one and positive in year 2) AND when the hurdle rate lower than the rate at which two projects have the same return

Question 24

A company should use the profitability index instead of the net present value method to rank investment projects when the investments have

Answer 24

different initial costs

Question 25

A corporation has not yet decided on hits hurdle rate for use in the evaluation of capital. This lack of information will prevent the corporation from calculating a projects…

Answer 25

Net present value (but NOT Accounting Rate of Return, Internal Rate of Return)

Question 26

Which capital budgeting technique would result in the same project selection as the net present value method

Answer 26

Profitability index